Capital Gains Exclusion

The Taxpayer Relief Act 1997 allows the homeowner to profit without paying tax on the sale of the property. The single homeowners are allow to profit up to $250,000 without paying tax, while the married homeowners are allow to profit up to $500,000 without paying tax.

Before May 7, 1997, the only way not to pay tax on capital gains is to use the capital gains to acquire another property. These homeowner tax breaks come as a surprise and relief for many homeowners. Now, the capital gains are tax exempt as long the sale comes after the law took affect.

There is no limit of the use of the Capital Gains Exclusion. The homeowners are able to avail as many times as possible.

However, the sold home must be a principal residence. That means the homeowner must have live at least two of five years on the sold home. It does not have to be sequence as long as the total comes over two years.

For any rental property, it can easily convert into principal residence. Suppose the homeowner decides to live on the rental property, the homeowner needs to stay at least two years on the rental property.

The home property does not have to be principal residence at the time of sale. So, the homeowner can rent out the property a few months before the sale of home property.

The married homeowner does not have to live on the same time. For example, the bride got married after a year and three month of living on the home. In nine months, the married homeowners can be tax exempted from capital gains.

Additionally, one of the married homeowner did not use the Capital Gains Exclusion within two years of sale. For example, the bride sold her home to live with groom. The bride used the capital gains exclusion. So, the bride and groom can only use the Capital Gains Exclusion after two years.

For special reasons, the homeowner can prorate the capital gains exclusion on health, employment, and unforeseen circumstances. For example, a heart attack may force a homeowner to sell before two years. Suppose the homeowner lived for twelve months, the homeowner is tax exempted for twelve / twenty four months portion of capital gains.

A great job offer comes along. The homeowner needs to move. For the homeowner to move, the homeowner needs to sell the home. The homeowner can also prorate the capital gains.

The unforeseen circumstances are national disaster, war, terrorism, death, divorce, separation, and multiple births.

The capital improvements increases the home values. As the home values increase, the capital gains also increase. You may worry how much tax that you have to pay. The Capital Gains Exclusion may well save you taxes. For the latest tax laws, you may want to get in touch with IRS, or tax advisors.

Will I Lose The Capital Gains Exclusion If I Gift My Home Through An LLC

Question: Dear Mr. Pancheri, I read your great article "Gifting Real Estate Under the Annual Gift Tax Exclusion." In this article you explain that an LLC can be used to accomplish this. I am considering an LLC as a method to gift my house to my son. I have two questions:

- Is there any change in the basis when membership units are transferred (that is, can I take advantage of the Capital Gains exclusion)?
Question: Dear Mr. Pancheri, I read your great article "Gifting Real Estate Under the Annual Gift Tax E
-Can property taxes continue to be used as an income tax deduction when property is in an LLC?

I appreciate your help. Thanks. E.R.

Answer: Dear E.R. - You ask some very good questions that need to be addressed before you start giving away your home, whether through an LLC or otherwise.

First, let's step back a bit and consider the consequences of selling your home outright to a third party rather than gifting it to your son. Under §121 of the Internal Revenue Code, you can exclude up to $250,000 of gain realized from the sale or exchange of your personal residence if you owned and used the property as your personal residence for at least two years during the five-year period ending on the date of the sale or exchange. This can be an important tax benefit if you meet the requirements and your personal residence has appreciated considerably in value. For example, if you purchased your home for $300,000 and then sold it for $550,000, your gain of $250,000 would normally be subject to a tax of around $37,500. However, under I.R.C. §121, this tax is avoided on the sale of a personal residence.

If you give your house to your son instead of selling it to a third party, the tax consequences are different. By gifting it to your son, you will avoid the capital gains tax. That's because a gift is not a sale or exchange of the property. In that case, your son would step into your shoes and assume your tax basis (i.e., $300,000 from our hypothetical above). If he later sells your home, he would pay a capital gains tax on the difference between the sales price and his $300,000 basis. Of course, if he meets the requirements of I.R.C. §121, he would be able to avoid the capital gains tax on the first $250,000 ($500,000 if he's married) of appreciated value as well.

Now let's consider the estate-tax benefits of gifting your home to your son rather than selling it. Let's assume that your overall estate is currently valued at more than $2 million ($4 million if you're married). In that case, if you simply deeded your home over to your son, you would pay no income taxes or gift taxes on the transfer. However, to eliminate the gift tax, you would have to use a portion of your unified credit against the gift and estate tax.

So, what's the benefit of gifting your home to your son now instead of giving it to him upon your death? By giving it to him now, you avoid the estate tax on the value of the appreciation of your home from the time of the gift to the date of your death. That could be significant in view of rapidly increasing property values. For example, if your home increases in value from $550,000 to $1 million from now until you die, then you will have avoided the estate tax on $450,000 - a tax of approximately $207,000 under current estate tax laws.

But, wouldn't it be better if you could eliminate the estate tax on the entire value of your home - not just the future appreciation? In my article, entitled "Gifting Real Estate Under the Annual Gift Tax Exclusion," I discussed the use of an LLC to do just that, by bringing the entire gift under the annual gift tax exclusion (currently $12,000 per year per recipient). That would not only avoid the estate tax on the appreciation in value, it would also exempt the current value from the estate tax simply because you wouldn't have to use any of your unified credit in the process. In our hypothetical, the net estate tax savings wouldn't be just $207,000 (the tax on the appreciated value), it would be roughly $460,000 (the tax on the $1 million date-of-death value.

The technique is quite simple. In order to give your home away in increments that are valued at less than the annual gift tax exclusion (currently $12,000 per year), you would transfer your home to an LLC in exchange for 100% of the membership units. It's important that you create enough membership units in the LLC so that the value of each unit is somewhat less than the amount of the annual gift tax exclusion. Then you can give your son one membership unit each year without having to pay a gift tax or use any of your unified credit against gift or estate taxes. Over a period of time, your house will be transferred entirely to your son without any gift or estate taxes. Of course, the article also discussed ways to accelerate this whole process by having your spouse elect to join in on the gift, and by making gifts to your son's spouse and/or children.

Now that we've put all this into perspective, let's tackle your specific questions. You asked, first, whether there is any change in the basis when membership units in the LLC are transferred to your son and/or others? Under current income tax laws, if you transfer your home to an LLC in exchange for 100% of the membership units, no gain or loss is recognized. The value of your membership units is assumed to be equal to the value of the property transferred (i.e., your home, in this case), and your tax basis in the membership units is deemed to be equal to your tax basis in your home immediately prior to the transfer. In our hypothetical, the value of your home was assumed to be $550,000 and your tax basis was assumed to be $300,000. Following the transfer, the value of your membership interests in the LLC is assumed to be $550,000 and your tax basis in the membership units is assumed to be $300,000. If you received more than one membership unit in the LLC at the time of the transfer (which you should in order to bring the value of each unit to less than $12,000), then your tax basis in each membership unit would be equal to your basis in the property transferred divided by the number of membership units you received. Assuming you received 47 membership units following the transfer, your tax basis in each unit would be $6,383.

If you then starting gifting membership units to your son, each membership unit that your son received would carry a tax basis equal to your tax basis in that unit (i.e., $6,383 in our hypothetical). If your son later sold one or more of his membership units, then he would incur a capital gains tax on the difference between the sale price and his tax basis of $6,383.

You also asked whether you could take advantage of the Capital Gains exclusion under I.R.C. §121 if you transferred your home to an LLC. The IRS has generally treated single member LLCs as disregarded entities, which means that if you transfer your home to an LLC and take back all the membership units, you'll still be eligible for the capital gains exclusion if the LLC then sells the home.

However, if you transfer one or more membership units to another person (i.e., your son) while the LLC still owns the home, then the LLC will be converted from a disregarded entity to a partnership for tax purposes. In that case, it appears that you will lose the capital gains exclusion if the LLC then sells the home while you still own some of the membership units. In that case, the LLC would have to file a partnership tax return, and the net profits would then be taxed to you and your son in proportion to your membership interests.

Incidentally, any real estate taxes paid by the LLC would be fully deductible for tax purposes. If you're the sole member, then the tax deduction would be claimed on Schedule A of your Form 1040. If you're not the sole member, then the taxes paid would reduce the net profits on the LLC's partnership return, and the resulting taxable gain reportable by you would be reduced accordingly.

While the loss of the Capital Gains exclusion may seem to be a deal breaker, it really shouldn't be. If your estate is large enough to be subject to a federal estate tax, then the estate tax savings will far out weigh any loss of the capital gains tax exclusion. Moreover, if your son owns the house and lives in it for two years, he will be able to use the exclusion himself. In that case, you won't have lost the exclusion, you'll just have shifted it to your son.

The Primary Residence Exclusion

One of the greatest tax gifts is the principle residence rules for capital gains on the sale of your home. So great is the principle residence tax exclusion that even married couples filing jointly are benefited to the same, if not greater, extent as single taxpayers. Now, some people may argue that there have been, are and will be greater gifts, but not much beats the simplicity of this rule. The basics of it are immensely easy to grasp: you own a house, you live in it for at least two years, you sell it and you don't pay any taxes on the gain. Gone are the days when the young homeowner (not wishing to sell and upgrade) had to save every receipt for every upgrade, every repair, every minor item bought at the hardware store. If you have lived in your own home for two years, you probably don't have to worry.

Of course, there are some technicalities associated with the general rule. They are pretty simple so first I will bullet-point the main ones:

o If you are single your capital gains exclusion is limited to $250,000.00

o If you are married your capital gains exclusion is limited to $500,000.00

o You have to own the home and it has to be your "primary residence" for two of the previous five years

What is your "primary residence"? Basically, it is a home that you personally live in the majority of the year. If you have a house in Palm Beach and one in Lake Tahoe and you spend 8 months of the year at the Tahoe home than that is your primary residence. But, keep in mind the 2 out of 5 part of the rule. Let's say that the next year you spend 7 months at the Palm Beach house. Then the Palm Beach home is your primary that year. See where I am going with this? You can primary more than one home at once over a five year period so long as each is your main home for at least two years during that five year period. Temporary absences are also counted as periods of use - even if you rent the property during those absences (but talk to your accountant about recapturing any rental depreciation).

Now don't let the five year requirement confuse you - it only takes two years to achieve the tax exclusion. The five year part is a bonus, allowing you some freedom. You don't have to personally use the home as your primary residence for two consecutive years or for the two years immediately before you sell, you just have to use it is your primary residence for two of the previous five years. But, it is also a limitation, you cannot live in a house for two years and then rent it for four years and then get the exclusion. You could live in it for two years and then rent it for three years and then sell it (so long as it is sold within the five year mark from when you first lived in it as your primary residence).

Also, bear in mind that married couples do not have to live together. So long as one spouse lives in the primary residence for the two years than the couple can take advantage of the $500,000.00 exclusion. But, they cannot primary two homes at once and get the $500,000.00 exclusion on both. If they live apart during the two year period and each sell their primary then they are each limited to the single taxpayer exclusion of $250,000.00 for each house.

If you have a home office or rental as part of your primary residence or run a business out of a portion of your property, your ability to maximize your capital gains exclusion largely depends upon whether the home office, business or rental was part of your home (in the same dwelling unit) or a separate part of your property (a separate building or apartment). If the business use of your home was contained within your dwelling unit then upon sale you will need to recapture any depreciation taken for that part of the home. But you will not lose any of the allowable capital gains exclusion ($250,000.00 for single taxpayers and $500,000.00 for married filing jointly). If the business use of your home was not a part of your dwelling unit then you need to bifurcate the sale by allocating the basis of the property and the amount realized upon its sale between the business or rental part and the part used as a home.

Remember, only one home can be sold in any two year period unless you and your spouse live apart, and even then you can each only take the single payer exclusion of up to $250,000.00. But what if you need to sell a home that you have not lived in for the full two years? The IRS tells us that in special circumstances you can sell a home before you reach the two year mark and get a pro-rated exclusion. An example of a pro-rated exclusion is, for example, if you are a single taxpayer and have to sell your primary residence for a qualified reason after living in it only one year than you could exclude up to $125,000.00. In other words, you lived in the home 50% of the requisite time so you can take 50% of the allowable exclusion. The special circumstances that qualify you for this safe harbor and allow you to take the pro-rated exclusion have to do with health (yours and certain qualified individuals such as close relatives), change of employment or what the IRS calls "unforeseen circumstances" (examples include death, natural or man-made disasters, multiple births form the same pregnancy, divorce) These circumstances also have to cause you to sell your home. Factors used by the IRS to determine causation include:

o Your sale and the circumstances causing it were close in time,

o The circumstances causing your sale occurred during the time you owned and used the property as your main home,

o The circumstances causing your sale were not reasonably foreseeable when you began using the property as your main home,

o Your financial ability to maintain your home materially changed, and

o The suitability of your property as a home materially changed.

1031 Exchanges and the Primary Residence Rule

What happens if you do a like kind tax deferred exchange (also known as a 1031 exchange) of rental property or other property held for investment and then later decide to live in the property that was purchased? It is crucial to your 1031 exchange that both the property sold and the property purchased are held for investment. The property purchased must undergo a holding period before it is resold or converted into non-investment property. That holding period should be a year and a day to avoid audit. After you have complied with the "held for investment" requirement by, for example, renting the property if it is rental property, then what? Well, you could sell the property and pay your taxes on that sale and all previous sales that were perhaps in a series of exchanges or exchange and defer the tax once again, OR you could live in the house as your primary residence. If you have a had a series of gains that you have deferred this is a way to extinguish your tax debt forever - all you have to do is move into your investment property once the holding period for it qualifying as an investment is over.

Gaining the primary residence exclusion for property that was 1031 property isn't as easy as the simpler primary residence rules talked about above, but it does allow you to take advantage of two loopholes at once! The main difference when primary residencing a 1031 exchanged property is that you actually have to hold the property for 5 years. The five year part here is a substantive rule, you cannot sell after only 2 years of ownership as you can if you were simply primary residencing a home that was not exchanged into. But that first year that you had to hold onto the home for investment goes towards the five year calculation. So, you rent it for two years and live in it for three, or vice-versa, so long as you kick the whole thing off with a one year rental period and live in it two of the remaining four years.

In this way, you can exclude up to a total of $500,000.00 worth of gain (if you are married filing jointly or $250,000.00 worth of gain if you are a single taxpayer) from the combined gains of the sale of the home you ended up living in as your primary residence, and any of the gains that you had previously 1031 exchanged. For example, say you purchased a duplex in May of 2000 for $150,000.00 and then in June of 2001 you 1031 exchanged the duplex (now worth $200,000.00) into a commercial building worth $200,000.00 (thus deferring $50,000.00 worth of gain). A few years later the commercial building is worth $300,000.00 and you do another exchange, this time into a nice single family home worth $350,000.00 (you have to put in an additional $50,000.00 to complete the purchase). You have now deferred a total of $150,000.00 worth of gain. Let's say you then choose to rent the home for the first two years that you own it and then you later decide to move into the home. You then live in the house for three years at which point it is now worth $700,000.00 and you sell it for this amount. You and your spouse have now effectively wiped out not only the $350,000.00 gain from the sale of your primary residence, but the previous $150,000.00 worth of gain as well.

Home Sellers Partial Exclusion

One of the major dilemmas that both married and unmarried home owners face is what happens to the $250/500k capital gains tax exclusion if you sell your home after owning it or living in it for less than two years? And what happens if you've sold another home in the last two years?

In these situations above you may be denied the $250k/$500k exclusion and have to pay tax on your home sale profits. If you have owned the home for less than a year you may even have to end up paying tax at your top income tax rate (up to 35%), instead of at the 15% long-term capital gains rate.

However there is hope, because you may qualify for a partial exclusion. You may not receive the full $250k/$500k but you could get something very close, and it could still be enough to safeguard you from paying any tax.

For example, those who purchased homes less than two years ago (and therefore do not qualify for the maximum exclusion) probably won't yet have $250,000 or $500,000 worth of capital gains that could be taxed. That includes many luxury homeowners as well.

Example

Ben and Jennifer purchased a $1 million house one year ago. Since then it has risen in value by 20%. The couple only need $200,000 out of their $500,000 maximum exclusion to protect them from paying tax. Owners of smaller homes, or homes that have risen in value by less, require an even smaller 'piece' of the maximum exclusion.

You may be asking yourself 'How do I qualify for a partial exclusion?' Partial exclusion is only available if the primary reason for your home sale is one of the following:

1. A change in work location

2. Health problems

3. 'Unforeseen circumstances'

As the IRS can never be 100% certain why you sold your home, they have introduced a number of 'safe harbors'. These are easy to apply tests which help you determine whether your home sale qualifies for tax-free treatment if you sell for work or health reasons or because of unforeseen circumstances.

If your home sale doesn't qualify under one of the safe harbors you may still qualify for a reduced exclusion if the evidence shows that your home sale was primarily due to a change in your work location, for health reasons or due to unforeseen circumstances. For example:

o Did the change in your work location happen while you owned and used the property as your home? If you lived somewhere else you'll struggle to claim the exclusion.

o Did you sell your home to help diagnose or treat a disease, illness or injury or to provide medical or personal care? If so you may qualify.

o Did you suffer a natural or man-made disaster causing you to sell your home?

To conclude, you must be prepared to defend your position if you have an audit. If the IRS thinks that, based on the facts and circumstances, you don't qualify you will have to pay back taxes, interest and penalties.

We hope that you have found this article a good introduction to partial exclusions. For more in-depth information may be interested in our guide Tax Loopholes for Home Sellers. Inside we explain the latest and best tax saving techniques and strategies that you can use today, plus dozens of clear examples.